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Rates market: Will hedging options evaporate?

Changes to the way banks run their rates desks will make it much harder for their clients – and the banks themselves – to manage through a turn in the interest rate cycle. How can investors protect themselves against a looming treasury sell-off?

"Some of the people who should be most worried about rising rates are credit investors," says Francesco Garzarelli, co-head of global macro and markets research at Goldman Sachs. "It’s all very well to say credit spreads could grind in 25bp to 50bp tighter in a strong economic recovery, but that’s not much use if rates blow out by 100bp."

The truth, of course, is that rising rates would affect all markets and all market participants – borrowers, investors, intermediaries – and few if any would emerge unscathed. The rates cash and derivatives markets are particularly ill-suited right now to help anyone hedge their potential losses.

For a start, investors’ potential hedging strategies are few and limited. The whole market in aggregate has benefited from falling rates and in aggregate the market will lose when they rise again. The distribution of those losses is the only uncertainty. However, those hoping to be more nimble than the rest and avoid the worst by going short, selling out, buying protection in the derivatives markets or adjusting portfolios to shorten duration, face new difficulties. Liquidity is much reduced from the pre-crisis era and concentrated in fewer instruments, mainly in benchmark maturities in the cash markets.

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